The Principle of Limited Liability - Case Study Example

Contents Contents Limited Liability 2 Joint stock Companies Act 1984 2 Limited Liability Act 1985 3 Limited Liability and Moral hazards 3 Case Example 5 Introduction 5 Analysis 6 Conclusion 7 References 8 ‘The principle of limited liability has no value and leads to immoral consequences’. Succinctly explain the principle of limited liability and discuss this statement. Limited Liability Limited liability as the word implies limits the liability of a certain party to a certain degree. The main consideration involved is usually financial in nature, which means that the interests of a party are limited to the degree of its financial investments. Therefore if a party has a limited liability towards a project of entity and that entity or project is sued the part with limited liability would only be liable to the extent of their own investments. On similar footings we can analyze the liability of shareholders in corporations. They are also not liable to anything more than their own personal investment in case the company is bankrupted or borrows any sums of money in its own legal capacity. However in such cases the law usually gives preference to lenders to protect their loans over investors. In United Kingdom the concept of limited liability came as late as the mid 1980s. Two main laws played a very vital role in this transition: Joint stock Companies Act 1984 This act was of the parliament of the United Kingdom and was aimed at incorporations of joint stock companies in the United Kingdom. Prior to the joint stock companies act of 1984 incorporations was only possible through two ways either private act or royal charters. Therefore businesses were usually being operated as unincorporated associations with members in thousands. This led to the problems of liability in case of litigations. All the people under the rule were equally responsible therefore it was impossible to sue so many people at the same time. Limited Liability Act 1985 The much awaited limited liability act finally came in 1985 which allowed investors to invest in corporations without having any liability except of their own investments. Limited Liability and Moral hazards In a typical agent principal relationship the agents is given the power to manage affairs of the principal. This would therefore give them complete legal authority to enter into agreements and legal contracts on behalf of principal. On a smaller scale this model would be without flaw or very little flaw for that matter. Examples of such everyday affairs are seen everywhere in day to day life, where principals pass on legal powers to agents on limited matters. In most cases usually little is at stake or the principal has personal ties with the agents and therefore can assure that a moral hazard has little chance of arising. In modern companies however the situations has changed. The structure of corporations tie thousands of different principals into relationships with agents they have not met ever. This creates a level of uncertainty for the principals as they are in ordinary circumstances totally liable for any actions being taken by agents. There are two different methods to cater this problem. The first method is to use insurance to safeguard the principal against any moral hazards of agents. The more common method however is as mentioned above, to formulate a limited liability contract. This type of contract would ensure that the principal is totally unaffected by the decisions taken by agents and any other moral hazards. There are many different implications of these limited liability contracts besides principal agent relationships. Banks sign limited liability contracts before undertaking investments in high risk projects etc. This limited liability can cause a number of problems which can directly affect both investors (in this case the principals) and the business environment in general. The primary drawback of this phenomenon has been seen in the recent global economic recession. The level of risk taking is really pushed up with the introduction of limited liability into the equation. If we study the events that led to the global economic recession we would realize that the concept of limited liability has a very large part to play in the drama that unfolded and resulted in the loss of jobs worldwide. The root cause of the recession comes on deeper analysis from the subprime mortgage crisis. The performance appraisals of most managers are linked to the amount of loans that are made or deposits acquired (in case of this example). They have no personal liability to the decisions they are making and neither do the investors. The investors therefore would always push them to take more risk and bankers took more risk in the situation mentioned. The loans made to houses were far above the appropriate risk levels but the bankers were motivated to take that risk as no one was liable; neither the investors nor the bankers. Therefore instead of taking appropriate risk they further securitized their highly risky loans and gave away more loans from the proceeds. Thus taking far more risk than would have been allowed if the liability was not limited. In hind sight it is very clear that if these banks were not all limited liability companies and were unlimited liability instead the situation would have been much different. First of all the investors would have kept closer eye on the proceedings and promoted a much more risk-averse approach. Moreover the agents would have known that any high risk decision would render themselves answerable to the people involved and therefore they would have made better choices. This is just a small example of the moral hazard that can arise from limited liability. The parties involved focus more on making profit than taking precautionary measures to reduce the levels of risk. The whole business environment is therefore effected. The unlimited liability companies also find it hard to compete on equal footings in such an environment where opponents on basis of their limited liability can engage in very risky decisions. This high risk renders for them very high returns thus making it impossible for others to compete on equal footings. Worldwide companies are engaging in measure to ensure that their businesses are not affected by this limited liability phenomenon. In the post recession environment banks and other financial institutions are much more cautious in lending to entities with limited liability. The practice of asking for personal guarantees from directors is becoming more famous. This ensures that directors keep a close eye on the proceedings and thus reduce the level of risk associated with doing business. Case Example Introduction Recently a new case of moral hazard has aroused related to limited liability company. This has once against raised eyebrows worldwide to the moral consequences of limited liability status. As explained above in wake of the financial crisis markets all around the world have collapsed. As expected the most effected markets is the real estate market. Huge investments in real estate were being made not only individuals but by pension funds, mutual funds etc. With the collapse of real estate many other companies such as insurance companies have also gone bankrupt. Recently the Dubai Real market also crashed terribly rendering hundreds of thousands of people jobless and bankrupt. At the center of this crash was Dubai World a company owned and operated by Dubai world. Dubai world was under billions of dollars in debt and the unofficial guarantee was that Dubai government was the owner and operator. The government however refused to take any guarantee of loans after the collapse. The director general of Dubai’s department of finance, Abdulrahman al-Saleh in an interview stated that as the company was incorporated as a limited liability company the Dubai government is not liable to settle the debts of Dubai World, although it was owned by the government. The minister further claimed that as the company as exposed to many different risks it would not be possible it to be guaranteed. Analysis The behavior of Dubai government in this case is a typical example of moral hazard. The behavior of Dubai World would have been much different if the government was exposed to the risk of its business. The Dubai government in the first placed initiated Dubai World and than even appointed its own representative to run it. The interior motive here was to support governments owns economic policies and economic strategies. The government according to the law can after using it for its own purpose still claim limited liability, which is morally and ethical wrong. The issue arises from asymmetric information on the issue. The Dubai government was in the best position to analyze the risk associated with the ventures of Dubai World. The investors on the other hand had limited information. They were relying on the fact that if Dubai World collapses the very strong Dubai Government would back its own organizations. Dubai World and its manager however were aware that they would not enjoy government backing in case of a failure. This was key information. The managers in Dubai World however did not share this information with the general public and continued to give impression that Dubai World was a project of Dubai government, thus implying that it was being guaranteed by Dubai government. The refusal of Dubai government to settle the debts of Dubai world has come across as a shock to the entire world. Thousands of investors have not only lost billions of dollars but also their trust in the financial system of Dubai. The economy of Dubai might recover in the near future but investor confidence has sadly been lost forever. Conclusion The case discussed above gives the worst kind of moral hazard arising out of limited liability. This shows that how limited liability can not only cause mammoth damage in terms of economic loss but also destroy investor confidence and thus the financial system. The argument here is not that limited liability should be completely abolished but that it must come with some special obligations and duties. The current corporations system has many advantages that cannot be matched with any other system. This system should continue to function but special consideration should be taken. The most important factor here is providing symmetric information to all investors. This would ensure that investors are completely aware of their investments and levels of risk associated with them. Recently the governments of both USA and UK have bailed out some of their major banks in order to curb the financial impact of the recession. This has set a bad precedent for the future. The banks although would have limited liability in the future for their actions but there will be an implicit guarantee that tax payers has unlimited liability for their actions. This is therefore not a solution to the recession but would only promote moral hazards in the future similar to the ones which caused this recession in the first place. References Biaisy, B. Mariotti, T. Rochetx, J &Villeneuve, S. (2009). Large Risks, Limited Liability And Moral Hazard. Read More